The Great Sharemarket Return: Mining Monadelphous

It began with an avalanche as the stock price fell into the abyss. What quickly followed was a blizzard of negative reports from the broking community, calling an end to the dream run for Monadelphous, one of the country’s best-run mining services groups.

There are some, however, who beg to disagree. Clime Asset Management’s team this week elevated Monadelphous into first position as a value stock in its weekly Value or Value Trap table.

Knocking mining giant BHP Billiton off its perch, Monadelphous has taken line honours precisely because of the heavy discounting it has weathered over recent weeks, which has seen its price now heavily discounted to Clime’s intrinsic value for 2013.

Clime analysts have an intrinsic value of $26.46 for the company, down from previous estimates of $27.61, for 2013. But that reduced value is well above the current market price, thus delivering what Clime argues is great value.

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The company ran with the bulls from September right through until late February. But its result on February 20 sent investors running for cover. The following day, almost every major investment bank analyst was in retreat, with most downgrading their investment recommendations, many to a sell.

It is not that the results were bad. In fact, Monadelphous delivered better-than-expected revenue and earnings with solid forecasts through until the end of this financial year. Instead, it was the outlook statement for next year and beyond, where the company indicated it would become increasingly difficult to maintain the pace of the past few years.

Given it essentially is a construction business for the resources industry, the reaction was understandable. With the investment phase of the resources boom expected to peak sometime this year, the contract pipeline is expected to shrink, threatening revenue growth, while added competition from underutilised rivals would attack margins.

After threatening to breach $28 just a few weeks back, it now is hovering just above $23 a share. At that price, it delivers a yield of about 6%. Given it is fully franked, that grosses up to 8.6%.

But there are other attractions for Clime. As is often the case with their top-line investment picks – safer companies that require a lower return to justify their place in the portfolio – Monadelphous has a good track record and a sound management team that own a decent slice of the business.

But wait! There’s more. It also has an ungeared balance sheet and levels of profitability and normalised returns on equity that are well above industry and market averages. As for the outlook, Clime describes it as solid but not spectacular.

The company anticipates that 2014 will be a year of consolidation. After such rapid growth, including a 46.2% increase in revenue and a 37.5% increase in net profit after tax in the recent half, that could be understandable, particularly given the number of projects put on ice after commodity prices plunged last year.

One factor that concerned most broking analysts was the contraction in margins in the most recent result, slipping 38 basis points to 6.13%. Cash generation was also weak as working capital increased, largely due to a lift in inventories.

But, as Clime points out, to compensate, the company has reduced capital expenditure to just $3 million during the half while the balance sheet – with net cash of $126.3 million and intangibles of just $5.4 million – remains strong.

Another factor that sent the analysts into a frenzy was the dividend. At 62c, the interim payout was 24% higher than the previous corresponding period. But it was below analyst forecasts, which fuelled selling activity and accelerated the stock price decline.

Some brokers also voiced concerns about the introduction of a dividend reinvestment plan, arguing that this may be a negative. Bank of America Merrill Lynch posed that this may indicate that funding is required to support weaker cash flow or that the company believes equity is expensive.

Citi, which has a sell recommendation, noted that in a decelerating growth environment, Monadelphous simply looked too expensive, particularly compared to rivals such as Worley Parsons.

But that situation may already have been rectified. When most brokers downgraded the company, its share price was north of $26, significantly higher than this week.

Clime analysts, meanwhile, are looking at a potential entry price of about $22, which would provide a reasonable margin of safety versus valuation.

Another positive, which didn’t receive too much airing in the broker analysis, is the growing contribution of Monadelphous’ two other divisions, maintenance and infrastructure.

Although best known as an engineering construction group, these overlooked divisions now provide about one-third of total revenue. The maintenance division alone was awarded $560 million in new contracts during the period, including the Curtis Island LNG project, the Karratha gas plant, a major contract with Rio Tinto and an extension for its management services with Chevron at the Gorgon LNG project.

There’s no doubt the mining boom, particularly the investment phase, is nearing its peak. While that will make life tougher for companies like Monadelphous, Mark Twain’s oft-quoted quip about his death being greatly exaggerated probably holds merit.

Figures are sourced courtesy of Clime Asset Management. http://www.clime.com.au/. To experience MyClime and the insights they can offer, click here www.clime.com.au/eureka.